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Breaking down retirement risks

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Published: Mar 24, 2014 5:00 a.m. ET

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The transition to retirement fundamentally changes the nature of risk.

A worthwhile approach is to distinguish risks based on whether they jeopardize the asset side of the household balance sheet, or the liability side (future spending needs) of the balance sheet.

Another division could be whether the risks impact society at a macroeconomic level, or whether they are individual specific. This allows for a consideration of four categories of risk as highlighted in the following figure.

Let's first consider macroeconomic risks to the asset side of the balance sheet. This is the upper-left quadrant. Poor market returns will translate into less financial assets on the retirement balance sheet. Even more deeply, financial market returns near the retirement date matter a great deal. Even with the same average returns over a long period of time, retiring at the start of a bear market is very dangerous because your wealth can be depleted quite rapidly and little may be left to benefit from any subsequent market recovery. The risk is essentially that retirees experience market downturns which are larger or longer than the downside tolerance built into their retirement plans.

As well, with interest rate risk, decreasing interest rates may provide capital gains for a bond portfolio, but they also lead to lower annuity payout rates and lower interest payments on reinvested funds. Increasing interest rates, on the other hand, may result in capital losses for a bond portfolio, though annuity payout rates and interest on reinvestments will grow. The risk here is if the duration of one's assets doesn't match the duration of their liabilities.

Next, let's consider the lower-left quadrant which includes more individualized risks that impact asset values. As cognitive abilities decline with continued aging, retirees are increasingly at risk of becoming victims of bad advice, fraud, or even outright theft. The danger with this is that nefarious individuals find a way to siphon off assets from the household balance sheet.

The death of a spouse can also impact the present value of assets on the balance sheet, especially if the deceased spouse owned pensions or annuities which do not continue to the survivor. As well, for households in which both spouses earned Social Security benefits based on their own records, these benefits will drop by 50%. For single-earner households, benefits will drop by 33%. Naturally spending needs may also fall after the death of a spouse, but there is a danger that assets drop faster than liabilities in these cases. Assets may also be jeopardized if the deceased spouse had handled most of the family finances, and the surviving spouse may not even be aware of how to access everything.

Finally, for households relying on part-time work in retirement, this human capital is part of the assets on the household balance sheet. But there is a risk of losing one's job involuntarily before the planned retirement date, or being unable to maintain desired part-time employment in retirement. Such unexpected job loss could be further compounded if it becomes necessary to sell assets at depressed prices to meet expense needs.

Next, we move to the upper-right quadrant, focusing on macroeconomic risks to the liability side of the balance sheet. In basic terms, the risk of increasing liabilities essentially refers to risks that spending needs will be greater than anticipated.

On the macroeconomic side, retirees face the risk that inflation will erode the purchasing power of their savings as they progress through retirement. Even with just 3% average annual inflation, the purchasing power of a dollar will fall by more than half after 25 years. With public policy risk, it's possible that the government could change the rules with costly implications for a retirement budget. Possibilities include increased taxes, increased contributions to Medicare, changing rules about IRAs, and so on.

Finally, in the lower right quadrant are more individual specific spending risks. First and foremost is longevity. Retirees may know their life expectancy, but their actual length of life on an individual basis is unknown. Though living longer than expected can be wonderful, it is also more costly and a bigger drain on resources.

Each additional year of life means an additional year of spending needs which must be financed. As well, health care prices tend to grow faster than consumer inflation, and it is hard to know how to plan for distant health care costs. Health care needs could force spending to exceed the planned level and jeopardize the retirement income plan.

Retirees may also find unexpected demands to help other family members, including parents, children, and grandchildren. A divorce can also completely change the picture for retirement income strategies. Retirees may also find that their housing needs changed in costly unexpected ways. Retirees may need housing with greater accessibility or with ease of access by caregivers.

Retirement risks could be classified in different ways. At my personal blog, I will direct reads to an alternative taxonomy which treats longevity risk as the overarching risk in retirement.

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